Citi, BofA Problems Seen Spreading to Other Banks

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The selloff in Bank of America and Citigroup may just be the beginning. Analysts now are predicting that the same problems hitting those two big banks will soon spread to the entire industry.

"There's certainly going to be more bank failures in 2009 as the economic backdrop continues to deteriorate and the smaller banks start to feel the pain," said Christopher Mustascio, managing director at Stifel Nicolaus. "Now you've got a full-fledged recession...Some of these banks are not going to be able to deal with that, and you're going to see failures."

Bank of America (NYSE: BAC) plunged to 18-year lows on Thursday, while Citigroup (NYSE: C) tumbled below $4 as investors worried about the financial health of both banking giants.

While JPMorgan Chase (NYSE: JPM) reported earnings Thursday that actually were better than Wall Street's diminished expectations, there was little other solace for an industry that seems headed for a year that could be even worse than 2008.

"If you look at the banking sector as a whole just in terms of price action in the group and what the market might be saying, I think one would have to conclude that there's more trouble that lies ahead," said Todd Salamone, analyst at Schaeffer's Investment Research in Cincinnati.

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Bank of America's problems stepped to the forefront of the mess as the company said it would need still more government bailout money from the Troubled Asset Relief Program, as it appears to have overpaid when it took over Merrill Lynch and all its toxic paper last year.

While some analysts were taking a wait-and-see approach on BofA's problems, investors dumped the stock in droves, with a stunning 200 million shares changing hands just in the first hour or so of trading.

"I'd really like to see what the facts are. We're dealing with a whole lot of shadows," said Anton Schutz, portfolio manager for the Burnham Financial Services Fund. "If there's TARP money, how much is it? If it's guaranteed, how much is it? The stock's getting destroyed, but the stock was getting destroyed before this news came out."

Schutz's funds include Bank of America, JPMorgan and Citi, and he said he's keeping the stocks with the notion that the worst of the news is coming to an end.

"The real question is, do these companies' valuations reflect the risk that's there?" he said. "I'm thinking we're a whole lot closer to reflecting the risk because many of them are trading well below book value."

Banks Will Fail--By the Hundreds

Whether the risk truly is reflected adequately remains to be seen as earnings season kicks into full fear.

JPMorgan reported Thursday, while Citi posts what are expected to be dismal numbers--as much as a $10 billion loss--Friday. Bank of America reports Tuesday.

The $700 billion Troubled Asset Relief Program, which banks can access to bolster their capital positions, will help ease some of the damage as will Federal Reserve moves to ease monetary policy. The liquidity moves of 2008 have lagging effects that should take root in the coming months.

But banks will fail, and at numbers large enough to cause alarm.

"I do think some of the actions taken by both the Fed and Treasury will limit the failure, especially at the larger banks, that we have seen in the late '80s or early '90s," Mustascio said. "But to think we're not going to see more failures in 2009 is probably naive."

The US saw 25 banks fail in 2008 and the number is expected to multiply this year into the hundreds.

While banks have been allowed relatively liberal access to the TARP funds, some are still burdened by huge losses suffered in the collapse of the subprime mortgage market as well as credit issues fed by consumer weakness during the recession.

In the case of Citigroup , its behemoth supermarket banking model became undone and the company was forced to sell its Smith Barney brokerage unit to Morgan Stanley (NYSE: MS).

At the same time, HSBC (NYSE: HBC) stumbled after analysts called into question its capital position.

Same Problems, Only Worse

In essence, the story of 2008 will be the story of 2009, only amplified.

That's because the mortgage contagion will spread beyond simply the subprime group and start to hit prime borrowers as well who cannot meet their obligations due to rising unemployment and the intensifying recession.

"Stabilizing the banks through direct capital injections was a good first step but before things can be really stabilized the government's going to have to find a way to take the toxic assets off the books of the banks," said Mike Carlson, a partner with Faegre & Benson's restructuring group in Minneapolis. "Until that happens, things are not going to be able to move very quickly."

As a result of the continued troubles, banks will have a hard time convincing investors that their institutions are stable, which will lead to weak share prices and diminished market capitalization.

Banks with an already weak position then will see their foundations crumble as the financial storm winds blow with more ferocity. Institutions with untenable business models, such as the one-stop-shop supermarkets, will find it difficult to survive.

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"Now we're seeing where banks have been very woeful pulling off effective integrations of these cultures," said Brian Hamburger, managing director of MarketCounsel, a regulatory compliance and business consulting firm in Englewood, N.J. "They've been performing poorly, with executing the cross-sell and cost-containment that they tout in every one of those business combinations seeming to fall well short. It's just not reality."

With fears that short-sellers again could swoop in on some of the weaker names in financials, investment pros are counseling clients either to stay away from most names in the space or at least hedge any plays by using inverse exchange-traded funds that pay when bank indexes move lower.

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Schaeffer's Salamone is avoiding the headline-makers like Citi and Bank of America, and when it is buying banks it's also taking puts on the Financial Select Sector SPDR (NASDAQ: XLF), a play that anticipates a move lower in the ETF.

"On the one hand there's a lot of negativity and there is an appeal to that. But there's only an appeal when the price action is not justifying that negativity," Salamone said. "This is more a sector you avoid. If you do dip your toes into certain banks, you do it in a very cautious manner by hedging."

In the meantime, big banks and small banks alike will get hit as investors avoid risk and and the shakeout in the industry continues.

"You always have a pendulum swinging too far one way and too far the other way. Over the course of time it swung too far to the side of the financial supermarket and now it's swinging back the other way," Carlson said. "Ultimately I think you're going to see risk again, but I don't think it will be for a decade or more."